Econ 208 Week 4

  • Created by: erised
  • Created on: 12-06-17 10:06

Deriving AD

  • Derived from the IS-LM equilibrium.
  • We assume an increase in prices. The supply of real money balances decreases shifting the LM curve to the left leading to a lower level of output. 
  • Therefore a higher level of prices leads to a lower level of output
  • The AD curve sums up this negative relationship between prices and output. 
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AS- Wage Setting

The nominal wage, w, depends on three factors:

  • Expected price level, 
  • Unemployment rate, u
  • A variable, z
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AS- Price Setting

Firms set their price according to :

    is the mark-up of the price over the cost of production.

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Deriving AS

  • Combine the price setting and wage setting by putting them both equal to w
  • Express unemployment rate in terms of output:  
  • Therefore for a given labour force, the higher the output, the lower the unemployment. 
  • Replace the uneployment rate with the equation in step 1. 
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Properties of AS

  • An increase in output leads to an increase in the price level. (Increase in Y leades = increase in N = decrease in u = increase in w = increase in p) - upward sloping. 
  • An increase in the expected price leads to an increase in the actual price (increase in Pe = increase in w = increase in P)
  • The AS curve goes through point A where Y=Yn (natural rate of output) and P=Pe. This means when Y>Yn, P>Pe and when Y<Yn, P<Pe.
  • An increase in Pe shifts the As curve up and a decrease in Pe shifts the AS curve down.
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Equilibrium in the Short Run

At point A the labour market and the goods market are all in equilibrium 

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Equilibrium in the Short-Medium Run

  • Wage setters will revise upwards their expectations of the future price level. 
  • This causes AS to shift upwards
  • This leads to a higher nominal wage and a higher price level.
  • The adjustment ends once wage setters no longer have reasons to change their expectations.
  • In the medium run, output returns to natural rate. 
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Effect of Monetary Expansion

  • In the AD equeation - an increase in M leads to an increase in the real money stock (M/P)
  • This leads to an increase in output and the AD curve shifts to the right.
  • In the short run the output and price rise.
  • The difference between Y* and Yn sets in motion the adjustment of price expectations
  • In the medium run, the AS curve shifts left and returns the economy back to Yn.
  • The increase in prices is proportional to the increase in the nominal money stock.

A monetary expansion leads to an increase in output on the short run but no effect in the medium run. 

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Effects of Fiscal Contraction

  • A decrease in public spending = decrease in output.
  • Decrease in output = real money stock rises = LM curve shifts to the right.
  • IS curve shifts left to restore equlibirum = both Y and r and lower than before

Deficit reduction in the short tun leads to a decrease in output and interest rates. In the medium run output returns to its natural level while the interest rate keeps falling further. 

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